Damned if they do, damned if they don't

On Wednesday, Ben Bernanke, the chairman of the Fed, came out to stress that the US economy still needs a monetary stimulus for the foreseeable future. Bernanke has, once again, sent out conflicting signals.

On May 21, and again on June 19, he hinted that the Fed might pull back its QE money printing if the US economy showed signs of a recovery. The financial markets thought the Fed might do some tapering-off in September or December. That led to a financial market rout. Asia, in particular, has been hardest hit, reversing earlier market sentiment that it would continue to be a major driver of global growth. The International Monetary Fund pointed out that emerging markets, including Thailand, would be facing capital outflow, higher rates, weaker currencies and slower growth. The Asia miracle ended in a hurry with Bernanke’s May and June remarks.

Yet it should be noted that Bernanke is managing the market expectations with his words – not his deeds. The Fed has yet to tame its QE, now going at a rate of US$85 billion a month. The Fed’s balance sheet continues to swell, rising to $3.5 trillion from $800 billion in pre-crisis 2008. 

The Fed’s economic forecasts have also been consistently off the mark, deliberately or not. The US economy grew only 1.8 per cent in the first quarter of this year, compared to 1.6 per cent in the second quarter. This sounds like the US economic engine is going to sputter along at 1.5 per cent a year. Yet the Fed predicts that US growth will range between 2.3 to 2.6 per cent this year. This means that the US economy must expand 3.4 per cent in the second half of this year. And this is impossible, given the IMF’s revision downward of global growth from 3.4 to 3.1 per cent.

The labour market has yet to recover. Unemployment is staying at 7.5 per cent, well above the Fed’s target of 6.5 per cent. So on economic grounds, the Fed can’t taper-off when the economic indicators do not support its wish. At the same time, there is a danger of maintaining the zero interest-rate policy, now running in its fifth year, for a sustained period. Somewhere along the line, inflation might break out. The reason that inflation has been subdued is because the banks hoard cash. The Fed’s QE money that goes into purchasing mortgage-backed securities from the banks mostly heads back to the Fed’s deposits. The banks are now depositing a combined $1.8 trillion at the Fed, earning 0.25 per cent. They apparently do not want to lend out to the weak economy.

Another factor that should worry the Fed is the sharp rise in the bond yield. The 10-year US Treasury yield stood at 1.5 per cent in May. Now it is approaching 2.65 per cent. A rise by more than one full percentage point in the bond yield bodes ill for bond investors and also for the housing recovery. Mortgage rates are based on the 10-year Treasury. Home applications for loans have fallen sharply so far due to the rise in the interest rate.

Finally, the Fed decides that it will continue with money printing. Once the printing press stops, the financial markets will fall apart. But if it keeps on printing money, at some point confidence will be lost and we’ll see hyperinflation. This is a dilemma for the Fed, which can’t find a way to dismount from the back of the tiger without being eaten alive.